"The Fed's Childishly Naïve Theory of Credit”
by Bill Bonner
Gualfin, Argentina. “Today, we return to familiar territory. We have seen it before: The slowdown in the economy. The overpricing of assets (particularly stocks). The huge increase in debt. The Fed's QE and ZIRP. But for all its familiarity, it remains strange... and mysterious.
Let's backtrack... The foundation for today's peculiar economy was laid in the 1960s and 1970s. In 1968, President Johnson asked Congress to end the requirement that US dollars be backed by gold. Then in 1971, President Nixon issued Executive Order 11615, which "closed the gold window." This meant the dollar was not directly convertible to gold. The supply of money and credit no longer had any anchor in a physical commodity. It could now be created ex nihilo and ad nauseam by private banks, aided and abetted by the Fed.
The PhDs running the Fed had a theory – one that seems childishly naïve but that, nevertheless, seems to work in practice (so far). The more you could get people to borrow, they reasoned, the more demand for goods and services there'd be... and the more the economy would produce to meet this new demand. This would give Americans more access to jobs, incomes... and the satisfaction of getting something for nothing.
The Credit-Driven Economy: The theory maintained that, as long as consumer prices didn't get out of control, banks could create as much credit as they wanted, stimulating growth. After some shilly-shallying in the 1970s, the new credit-driven economy began to take shape in the 1980s. Since then, $33 trillion of spending, buying, investing, producing, consuming and speculating has taken place – all funded by credit. Had the level of debt to GDP kept steady, there would have been about $1 trillion a year less economic activity over the last three decades.
Is that a success for the PhDs? Or what? "Or what?" is our guess and our question.
During almost that entire time – from 1980 to 2013 – consumer prices did not get out of control. Instead, they seemed to come more under control – with a gradually falling CPI (aided by jiving the figures!) from over 13% in 1980 to barely 1% today. But here is the curious and incomprehensible part. If you earned $100 a week, you could normally spend $100 a week. If you had $10 in savings, your savings would represent stored-up buying power. So you might choose, in one week, to spend that too. In that week, you would enjoy $110 worth of what the world had on offer. And the economy around you would enjoy an extra $10 worth of demand.
But the $33 trillion spent by Americans over the last four decades or so did not come from savings. Instead, it came out of thin air – from the banking system, which contrary to the common belief that it requires some pre-existing money (in the form of cash deposits or reserves) to make loans, simply creates them out of nothing.
A Vexing Question: In other words, this credit creation did not represent resources that had been set aside – like seed corn – to prime future growth. No one ever deprived himself of a single meal, or as much as a single beer, to save the money. No one troubled himself to work even a single hour to earn it. No one toiled or spun...
Now, if the guy with the saved $10 lent it to someone else... and the borrower spent it... it would have the same effect as if he had spent it himself. So, if the economy had borrowed $33 trillion from savings... and spent it... you'd see the same effect, right? And what if the $10 or the $33 trillion couldn't be paid back? Then the savings would be lost. The savers would be out. But at least it would make sense. The automobiles, shopping malls, vacations, retirements, silly gadgets, health-care scams, parasitic legal actions and false-shuffle financial products would have been funded by real money. They would exist for a reason, if not necessarily a good one.
But what happens if the $33 trillion of pure credit, unbacked by savings, cannot be repaid? Who is out? Who loses? And how did all those real things... the $33 worth of goods and services... come to exist in the first place, if there were no real money or resources ever made available to fund them? Is anyone else concerned about this? Are we all alone here?”